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Fixed Income

Navigating Recession, the Fed, Inflation and Borrowing

Jeff Klingelhofer, CFA
Co-Head of Investments and Managing Director
19 Sep 2023
15 min listen

Jeff Klingelhofer discusses when the recession may finally arrive, whether the Fed will tolerate inflation above its 2% target, and that surging government debt.

Read Transcript

Navigating Recession, the Fed, Inflation and Borrowing

Jeff Klingelhofer:  As we step back and look at all of the incoming data, we’ve been surprised we’re not in a recession, but as we look forward, recession is delayed. It’s not canceled, and we continue to expect that as we play for the first half of 2024 that things’ll look notably weaker than they are today.

Robert Costello:          Hi, and welcome to another episode of Away From the Noise, Thornburg Investment Management’s podcast on key investment topics, economics and market developments of the day. I’m Robert Costello, client portfolio manager for global fixed income. We’re watching a series, Three Questions and Three Answers, with Jeff Klingelhofer. Jeff is a managing director and co-head of investments on Thornburg’s global fixed income team. Jeff, thanks for joining us today. The latest quarterly GDP print came in at just above 2 percent annualized which, although not robust, is solidly in positive territory. The latest non-farm payroll figure also came in at a reasonably solid 187,000 jobs added. Where is recession that so many have expected for the last year or so? Do these data points strengthen the case for a so-called soft landing, and do you expect the economy to fall into recession in the coming quarters?

Jeff Klingelhofer:        Yeah, I think it’s been incredibly confusing to start this year. I, I think if we rewind the clock and we remind ourselves coming into this year, we and the market were expecting a, a notably more significant downturn. Now a couple of points on that. One, first of all, to your, a point to your question, we’re, we’re not there. We, we aren’t in a recession. At least certainly it doesn’t feel like we’re in a recession, and the data doesn’t tell us that we’re in a recession. The second point though is, becomes the broader part of the question is the recession just delayed or is it outright canceled. We continue to believe that recession at this point is not in the canceled category. We are continuing to march forward, so the timing has been incredibly uncertain, and we have to ask ourselves the question why, but first what the data tell us today is if you would’ve asked me, and I think if you would’ve asked most market, market participants to say first and foremost would we be in a recession in 2023, the answer would’ve been a resounding yes, but wouldn’t, you would’ve asked them a, a follow-up question to describe what the data would look like leading into that recession, right. What we would’ve talked about was a significant pull back of consumer and corporate lending, and we’re seeing that in bank lending data. We would’ve talked about a fall in consumer confidence, and we’re seeing that. We would’ve talked about a general pull back in broad spending especially at the, the corporate level, and that’s exactly what we’re seeing. We talk about early-stage delinquencies rising and roll rates from 30 days delinquent to 90 days delinquent rising, so all of the data, while it’s not pointing to an outright recession, it’s absolutely pointing towards a slowdown, and, and the question of course becomes how far does that slowdown go. You know, I think one of the things that we’ve, as a market and, and myself failed to account for was the incredible amounts of COVID stimulus that, that was just on the sidelines and, and saved up, and it brings me perhaps to one of the most important points, is that as we look backward, a lot of that COVID stimulus was not evenly distributed. That is to say that lower- and middle-income borrowers benefited tremendously more from a lot of that stimulus than, than the high-income borrowers, and unfortunately inflation and the effects of high rates are also not created equal. I was fortunate, I was able to lock in a, a mortgage rate at slightly below 3 percent, and today I’m able to, to take that cash that I would’ve spent on a home, and instead I’m earning 5 1/2 percent in money market and other interesting investments, and we’re seeing the same thing at corporates. Broadly, very high-quality net cash positive. Think of very large tech is actually making more money today because they borrowed at low rates and they turned out their debt, and now they’re earning more on it, but the flip side is not true for the lower income consumers. Inflation has had a much more profound effect on them, and it’s forcing them to deplete their savings at a really rapid clip. On top of that, as we look forward, some of their employment conditions are, are starting to deteriorate. Now they had been incredibly strong, but they’re deteriorating. The exact same is true at the company level where very high-quality companies are, are net cash positive and actually benefited from higher rates, but small and mid-cap companies that’s not the case, and small and mid-cap companies are broadly what drives the economy. So, as we step back and look at all of the incoming data, we’ve been surprised we’re not in a recession, but as we look forward, recession is delayed. It’s not canceled, and we continue to expect that as we, we play for the first half of 2024 that things’ll look notably weaker than they are today.

Robert Costello:          In his Jackson Hole speech, J. Powell stated that the inflation target is still 2 percent. His statement presumably quelled any speculation that they may declare victory on inflation prematurely, but is he being sincere? Do you think the Fed will announce mission accomplished if inflation comes down to 2 1/2 percent or even 3 percent?

Jeff Klingelhofer:        I would say a couple of things. I think the best way to answer this question is for us to back up and think about where that inflation target even comes from. So the first point is the Fed is actually incredibly unique in the world of central banks. Most central banks have a very defined single mandate, and that single mandate is price stability or inflation at a 2 percent level. It’s very deliberately defined. The Fed, on the other hand, actually is tri-mandate central bank, so we oftentimes talk about two mandates. We talk about price stability which is that 2 percent objective that you talk about. We’ll come back to that, but the second part of their mandate, or at least of their dual mandate as we often refer to it, is maximum employment, and so what it is think about it as a teeter totter. A teeter totter between solid growth which is great. We all want that, but of course we don’t want growth at the cost of significantly high inflation. So, the Fed has to balance that. Now there is a third objective, one that per their congressional charter is defined as moderate long-term interest rates. We’ve oftentimes talked about this as compressing the wage gap. It’s flexibility on how they pursue those first two policies, but as we think about that 2 percent inflation objective, that’s actually relatively new in the Fed’s history. So, it was Ben Bernanke in January of 2012 who actually defined what price stability meant, and he defined it as 2 percent inflation as measured generally by core PC which is the Fed’s preferred inflation measure. Now the history of their ability to actually achieve that 2 percent target is, is pretty sketchy, so in the 4 years going into that January of 2012 date, the average inflation over that 4-year period was only 1.36 percent. Of course, right at January 2012 it was 2.06, so it seemed like a pretty opportunistic time to say great, mission accomplished, and from here on out our goal is 2 percent, but since 2012, up until the recent spike in inflation, it’s only averaged about 1.6 percent, and more importantly to me it spent very little time even close to that 2 percent objective, so it’s only spent about 15 months between 1.8 and slightly over 2 percent. The other 70 months basically it spent below. Now I’m not trying to be too critical of the Fed. Targeting inflation is incredibly hard to do, but to me it highlights first two things. One, it’s really, really hard. Inflation is a very difficult objective to define, and we don’t necessarily know what drives it, but two, and even more importantly, the Fed has defined that 2 percent as a symmetric target, and so today we’re s, pretty systematically overshooting that, but that’s off a decade and a half of systematically undershooting it, and so the way I would think about it is, it’s a very flexible mandate. I think in the long term it’s probably reasonable to say the Fed wants to get to 2 percent, but the way I would say is I think the Fed is very tolerant today of targeting inflation north of, of even 3 or perhaps even close to 4 percent so long as it comes from good inflation which they deem to be wage pressures from low wage income earners.


Robert Costello:          Interest payments on the federal debt have skyrocketed in recent years nearly doubling to $1 trillion in the second quarter of 2023. Fitch recently downgraded US Treasury debt citing, among other factors, the threat of an unsustainable budget outlook and the unwillingness of either political party to address the issue. At what point could debt challenges become problematic for the fixed income markets?

Jeff Klingelhofer:        Yeah. It’s, it’s, it’s a tough one. I mean there’s really two broad philosophical mindsets of what drives fixed income markets, and on one side it’s the classic supply and demand, and so the challenge here is that we’ve got notably more supply on the back of still very large deficits. Huge deficits outside of a war time, and, and especially maybe outright concerning given the level of, of low unemployment, and from that perspective we have a lot of people pointing to the increased supply and, and issuance of treasuries and, and pointing to a perhaps runaway problems from, from the bond vigilantes as, as they come back to restrain the, the fiscal side of the equation. I don’t personally sit in, in that philosophical camp of supply and demand. I sit a little bit more on just the mathematical side of the definition of the rate on a 10-year treasury is the market’s expected rate of short-term rates from the Federal Reserve between now and 10 years, and so I, I’m, I’m not tremendously concerned. I mean I think what we’re seeing from fixed income investors and ourselves included in, in the world of higher rates, the world of fixed income is tremendously more interesting, and so even if we go back to the camp that I’m not in, the supply and demand, demand is increasing, but it’s a, it’s a, it’s a fascinating question. I think really if I look at it from either side, if we rewind to the first question we talked about is why aren’t we in a recession, we all thought we’d be in a recession because rates had moved higher, and as those higher rates act as a break on the economy, it forces us potentially into a slowdown and ultimately, in my belief, a recession. The exact same would be true here, and so if we stay at 4, low 4 percents, which is where we are roughly today, then I, I don’t think it’s tremendously problematic, but if the Treasury  continues to issue and rates do shoot notably higher, it only increases the likelihood of a, of a recession, and increases the depth of that recession which of course then would force the Federal Reserve to cut rates, and we’d see the opposite. So, to me it, it’s not a tremendous concern. It’s something we’re keeping our eye on. I think it’ll cause a lot of noise in, in the media, but I don’t think it’ll cause a lot of noise within actual underlying treasury rates and, and financial markets.

Robert Costello:          So, Jeff, we promised three questions and three answers, but we’re gonna throw in a bonus question that’s not markets related. It’s the start of the new NFL season. So, tell me, who do you think will play in Superbowl 58 in Las Vegas in February?

Jeff Klingelhofer:        My favorite question of all, right? If, as if it’s not hard enough to, to predict future financial markets. Predicting the NFL. I’ll take a little bit of a swinger here. I’ll say the, the Dolphins versus the Lions and kinda quick logic there is that both of those teams have had talent, but unfortunately in the past they’ve had a little bit of a challenge bringing that talent and, and pulling it all together, and so I don’t know. I’m feeling lucky and maybe for, for both of those teams this is the year where it really comes together, so my official pick, the Dolphins versus the Lions.

Rob Costello:   Thank you for an informative discussion today, Jeff. We look forward to doing this up again next time. Also, I want to thank you all for listening. You can find this and other episodes of Away from the Noise at Thornburg.com/insights as well as on Apple Podcasts, Spotify or wherever you prefer to listen to podcasts. Please follow our show and give us a review. You can also visit Thornburg.com to check out the variety of great content about interesting topics surrounding markets and the economy. Thank you all again and have a great day.

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